Is Fundamental Analysis important in Forex Trading?
There seems to be tremendous focus on Technical Analysis in the Forex industry. So much so that most retail traders think that Fundamental Analysis is not really important.
Some even respond by saying that they have never heard of Fundamental Analysis. Others argue that you only need the price charts to know where the market is going.
A very important question that we ask beginner traders is whether they know what methods the institutional traders focus on?
Most retail traders are unaware that the vast majority of institutional traders predominantly uses Fundamental Analysis in their trading.
Let that sink in for a moment…If Fundamental Analysis was redundant, why are the best traders in the world using it?
This article is not aimed at convincing anybody to suddenly drop all of their charts and start trading with the Fundamentals. For some that would be a very big move into the unknown.
So rather think of this article as an introduction into the reasons WHY WE think Fundamental Analysis is important in trading.
We are very strong believers in the Fundamentals, so we are naturally very biased about it.
Hopefully after this article you would have enough info to make up your own mind about the subject.
Majority of Retail Traders never become profitable
Statistics show that majority of retail traders never succeed in trading. There is a rumour going around in the forex industry which claims that only 5% of retail traders are consistently profitable.
We are not sure about the validity and accuracy of that 5% number. However, even if it was just partly true, that is a scary number. From our experience, we think that number is a bit small, but still close to accurate.
So why are there so many retail traders that never become profitable?
There is a plethora of reasons why majority of retail traders never become profitable.
However, the most common reasons are due to emotions, commitment, risk management and methodology.
We will briefly discuss the first three of these and then focus the rest of our attention on methodology.
Also important to note is that the four points ARE NOT RANKED in order of importance as all of them are very important.
This is defnitely one of the biggest culprits why majority of retail traders fail. Our emotions can affect our trading in more ways than people realise.
Emotions has the ability to turn the best traders into gamblers. It is not that emotions in itself is bad for trading. Rather, it is uncontrolled emotions that can be dangerous in trading.
Uncontrolled emotions will cause traders to abandon their process and make unnecessary mistakes. A trader who does not have control over their emotions is like a ticking time bomb.
Traders are exposed to a unique type of stress.
Financial risk taking ignites a type of stress that only high performance athletes will understand.
Performance pressure is something that not everybody can deal with. Consequently, emotions are one of the biggest reasons why retail traders fail in trading.
The other reason why majority of retail traders fail is due to a lack of commitment. It seems like most new traders fail to fully understand how difficult Forex Trading really is.
Trading is one of the most challenging endeavours a person can undertake. Being able to trade successfully will take a lot of time to master. There are no shortcuts.
Majority of retail traders fall into the trap of thinking that trading is very easy. They soon realise that this is not the case. After numerous failures the average retail trader simply gives up.
A lot of this is to blame on false advertising. There are a lot of scammers out there trying to convince people that trading is a get rich quick scheme.
When beginner traders realise that this was a lie, they normally give up on trading entirely. The skills required to make it as a consistently profitable trader cannot be learnt overnight.
Unfortunately there is no pills you can take which will make you committed, you either have it or you don’t.
This is a big one. We think a lot of retail traders will be able to go from failure to success if they learn to manage their risk.
Proper risk management is a critical success factor in trading. It doesn’t matter how good you are or how well you choose your trades.
If you don’t have good risk management you will eventually bust your account wide open.
Statistically, all traders will eventually experience losing streaks. Losing streaks are periods where traders experience successive losing trades in a row.
This is something all traders will go through. It is during those times that risk management means the difference between success and failure.
Retail trader try to risk too much per trade and end up wiping out entire accounts. Risk Management is crucial and without it there is no chance for long term success in trading.
What about the retail traders that has commitment and follow proper risk management and has their emotions in check?
Why are some these retail traders still unable to achieve consistent success and profitability? If they have the first three elements in place why can’t they achieve success in trading?
We believe the answer lies within their methodology. There is something that majority of these retail traders have in common.
Most of the retail traders in the market only trade with mechanical Technical Analysis based trading systems…
Think about that for a second. Is it possible that the methodology some retail traders use are causing them to consistently lose money?
In our opinion the answer to that question is YES! We believe that purely Technical based trading systems carries a lot of the blame.
Let us explain this in some more detail.
Technical Skills versus Technical Systems
Now before we continue, let us just make something very clear.
We are not against Technical Analysis! We use Technical Analysis on a daily basis in our trading.
Technical Analysis skills should be an essential element of your trading Methodology.
BUT, there is a MASSIVE difference between Technical Analysis skills and Technical Analysis systems. Most retail traders fall into the trap of blindly following mechanical technical trading systems.
The reason why so many retail traders flock to mechanical trading systems is because they are simple to follow and implement.
On the other hand, skills are something that required time and experience. Unfortunately, some traders are not willing to put in the time and effort to build the skills they need.
They would much rather rely on a mechanical system to tell them what to do. They would much rather let someone or something else do the thinking for them…
Retail traders like the idea of simply have a screen full of fancy indicators that tell them what to do.
They like the idea of being able to trade by systematically ticking boxes and following strict mechanical rules.
Traders like this because they feel a sense of safety by surrounding their trading methodology with fancy indicators and strict rules.
Reasons why Technical Systems does not work consistently
There are a couple of reasons actually. The first one is quite simple. Technical systems does not work consistently because the market is DYNAMIC.
The meaning of the word DYNAMIC is very important…
Dynamic : “(of a process or system) characterized by constant change, activity, or progress.” (thanks Google)
The market is always changing. The reason for this is because the market is driven by people. People are emotional beings you know. They feel, and then they do.
For example, the market might FEEL greedy and decide to trade accordingly. Similarly, the market might FEEL afraid and decide to trade accordingly.
There are just too many variables connected to trading which mechanical systems cannot account for. A trader who uses their skills to trade can pick up on the subtle changes in sentiment in the market.
As long as the market is driven by people a purely technical based system will find it very hard to work consistently.
It might have periods of success for sure, but no consistent profitability in the long run.
Technical SKILLS on the other hand is incredibly valuable because skills are dynamic. A skilled carpenter can adapt his approach based on different wood types and shapes.
His skills allows him to be dynamic in his approach…
What methodology does Institutional Traders focus on?
We just saw why Technical Skills are important in Forex Trading. However, Technical skills is only one part of the equation. The smallest part actually.
The biggest skills required in your trading methodology is Fundamental Analysis. Oops! Not what you were hoping to hear, right?
Most retail traders envy the trading success enjoyed by Institutional traders. However, there is one big difference between majority of retail traders and institutional traders.
Most retail traders are more focused on getting the next best indicator or the next best technical system. Comparatively, most institutional traders places far more emphasis on Fundamental Analysis.
If the most successful traders in the world put more focus on Fundamental Analysis why should retail traders be any different.
One of the reasons is because Fundamental Analysis is a skill that takes time to learn. Most retail traders does not want to take the time to learn that important skill. They would much rather buy a new robot or strategy.
Why does Fundamental Analysis make such a big difference?
The reason why Fundamental Analysis is so important is because it explains WHY the market is moving. Technical analysis is great at examining HOW the market is moving, but the Fundamentals explains WHY.
Fundamental Analysis allows traders to evaluate the mood of the market. This is based on many different things…
Institutional traders evaluate the above variable and then establishes the most likely direction for different currencies. They don’t rely on indicators to show them buy or sell. They don’t rely on technical systems telling them where to trade.
They anticipate currency moves based on their Fundamental and Sentimental biases. Only after a bias has been established should Technical skills be incorporated.
Unfortunately, for a lot of retail traders, the thought of having to learn Fundamental Analysis skills are just too much.
Interestingly, professional trading firms are willing to pay up to $24,000 per year for a single Bloomberg Terminal subscription. If the institutional traders would spend so much money on Fundamental tools that should tell us something.
Why would these banks they do that if Fundamental Analysis information was not important? This fact alone should beg the question of why Fundamental Analysis is important in Forex Trading.
Long term and Short term Fundamentals
Something interesting that we have noticed is that a lot of retail traders think that the Fundamentals is only valid for long term trades. However, this could not be further from the truth.
The Fundamentals plays a very important role in the short, medium and long term. Of course, the biggest focus for Fundamental analysis is on the bigger picture view of the various economies.
All of this revolves around interest rates and what the expectations of current and future interest rate hikes might be. However, the Fundamentals are excellent for finding short and medium term trade biases as well.
This is called Market Sentiment. So what exactly is market sentiment in trading?
Market Sentiment refers to the short to medium term mood of the market.
Sometimes the short to medium term sentiment can cause a currency to move in the opposite direction of its longer term bias.
The short to medium term sentiment is how the market is FEELING towards a certain currency.
Let us look at an example below…
From the chart above we can see how Sentiment can cause the market to move against the longer term Fundamental bias. Without knowledge of both it would be very difficult to determine the highest probability trade directions.
What advantage will Fundamental Analysis give me?
This is where we think a lot of traders is missing out of the bigger picture. As we mentioned above, there is nothing wrong with great Technical Skills. However, trading is a probability game.
There is a way of increasing the effectiveness of even the simplest Technical trading approach.
That is, by being able to choose only the highest probability trade directions. This is done based on the Market Sentiment and Fundamental Analysis. It’s that simple…
It is like driving a car. Let us image that you have the best car and you have the best driving skills known to mankind. All of that doesn’t matter if you can’t see where you’re going.
In the same way, Fundamental Analysis gives us a way of seeing the market more clearly.
Knowing when to stay out of the market due to the Fundamentals is more important than any signal from an indicator.
The place for Technical Analysis?
So where exactly does Technical Analysis fit into the picture? Fundamental Analysis is what we use to choose the highest probability trade direction.
Then we use Technical skills to determine the best possible entry and exit levels. It’s that simple. However, it does not work the other way around.
Without Technical skills you will not be able to execute, manage and exit trades properly. However, they should happen after Fundamental Analysis has been done.
Knowing what current sentiments are driving the market is essential to consistent trading success. Traders need to ask themselves how they think the market will react?
What will the market’s reaction be towards certain announcements or economic data? Once you have that information, even simple Technical methods will be more consistent.
There is more to trading than just looking at price charts and following technical systems. Consistency in trading is something majority of retail traders desire.
In our opinion, the only way to get there is by learning to use both Fundamental and Technical analysis methods.
The Fundamentals are definitely more challenging to study and master. However, it is absolutely worth the effort and time if you want to take your trading to the next level.
For many traders out there, the Fundamentals is the last piece to the puzzle. For many retail traders, the Technical systems they love and adore might be the very things that are holding them back…
Trading is not a game and financial risk taking can be very dangerous. If you are a beginner trader make sure to start trading on a demo account first. Never risk real money in trading until you have received proper training. Remember, that trading without knowing what you’re doing is not trading, it’s gambling.
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